Why You Lose Money in the Stock Market
Stocks go up and down, but over the long haul, the trend has been up - way up - and it has been this way for generations. That being so, why do so many of us actually lose money in the stock market?
The simple answer is that we do it backwards. One of the oldest adages on Wall Street is that to make money, we need to "buy low and sell high" - which is obvious enough. But even though we try to do it that way, we too often "buy high and sell low." Why are we so dumb (or, to put it more nicely, so "unlucky")?
The underlying answer to this question is that we are built to fail in the markets. Some of our key instincts and intuitions - though helpful to our prosperity and even our survival in other ways - work against us as investors.
The most important example is our herd instinct. Humans are not, strictly speaking, herd animals, but we have developed as a social species. And when there is a mortal threat and everyone starts to run, it usually pays off for us to run with the crowd instead of waiting until we've collected all the data on our own. Last one into the pool is some predator's lunch!
This strategy (instinct, really) helped keep our ancestors alive, and does the same for us today in some circumstances. But in the markets, it puts us at risk. When we hear on the news that stock market averages are setting records, we are energized to follow the herd. What if they're right? We'll lose out (and we'll have to listen to our relatives and friends brag about the killing they made). But we're not fools. We don't just leap in. We watch, we wait, we think about it, and finally we make our move.
And we've just assured ourselves of a disaster. Instead of "buying low," we just "bought high." All we can hope for, is for the "greater fool" theory to kick in: that even though we made a poor judgment, there is always someone with worse judgment who'll buy us out at a still higher price. And that can work, for a while. But when things start to turn, as they inevitably do, they often turn so fast that they start a stampede, and even the fools turn and run. So you're left with investments you've overpaid for, that you can sell only at a loss.
But instead of selling immediately and cutting your losses, you wait for redemption. The market will turn again, and you will still get your money back, maybe even a little profit. And sometimes it does turn around quickly. But every so often, it just keeps going down, and you get more and more worried, more and more despairing. The only way to stop the worry is to finally sell the thing, and you do - at a big loss.
You have bought high and sold low.
At least you have the comfort of being part of the crowd. The majority of individual investors (and a lot of professional investors as well) do exactly the same thing - because we're all human, and we all share those instincts.
How can you avoid this?
1. Just stay out of the stock market (and other speculative investment markets, like commodities or real estate, for example).
2. If you do invest, especially if it's through a 401(k), 403(b), IRA, or other such plan, don't track your balances too closely. If you don't need to liquidate your money soon, then do not move your money out of equity funds after they have already fallen significantly in value; and if you're not going to move it, then don't even look at it. Start looking again when the markets recover - and if you want to get out, get out when the values are high (though this means running against the herd!).
3. Also, if you do invest, "buy low." You cannot "buy low and sell high" if you buy high. Another Wall St. adage says that you should invest "when the streets are running with blood." Gruesome, but true. But again, that means running against the herd. When markets crash, it's because most people want to sell, and few people want to buy. When markets fall 30 percent, 40 percent, 50 percent, these are not times to sell, but great opportunities to buy, if you have the means. It doesn't take brains, just the ability to resist panic. If you can't resist panic, then find an investment manager who can, and leave it to him or her.
4. Don't worry about buying at the top or selling at the bottom. Hitting those magic points is just a matter of luck. The rule is not, "buy at the bottom, sell at the top," but rather, "buy low, sell high." Not even the savviest investor wins all the chips on a regular basis. You just need to win a decent number of chips most of the time. If something got left on the table for someone else, that's fine.
5. Understand the basics, or don't play. If you are not comfortable with stocks (and good for you, if you're not), don't assume that bonds are safe. Bond values go down when interest rates go up. Since interest rates are close to zero right now (January 2010), they almost have to go up from here, and when they do, the value of any long-term bonds or bond funds you own is likely to drop.
All markets are cyclical. Whatever kind of investments you make, you should buy low and sell high - and if you are patient and disciplined, you will have opportunities to do exactly that. If you have an investment mentality, there is almost always a good cyclical opportunity.
But it is hard to buy low and sell high, so if you don't have the stomach for it, or if you really just can't afford to lose any money, don't be an investor. Put your money someplace safe.